ECS3703. Tutorial letter 201/1/2015. International Finance. Semester 1. Department of Economics ECS3703/201/1/2015 IMPORTANT INFORMATION:

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1 ECS3703/201/1/2015 Tutorial letter 201/1/2015 International Finance ECS3703 Semester 1 Department of Economics IMPORTANT INFORMATION: This tutorial letter contains important information about your module.

2 CONTENTS Page 1. The examination Errata Answers to Assignment Answers to Assignment Copy of the Nov 2014 exam paper General information Communication with lecturers

3 ECS3703/201 To date you should have received the following study material: Study guide: Study guide for ECS3703 Tutorial letter: 101/ Introductory tutorial letter and assignments * *** * 3

4 Dear Student We trust that you find the module interesting. 1. THE EXAMINATION The examination paper consists of six questions of which you must do four, each counting 25 marks. The format is as follows: SECTION A consists of TWO compulsory questions. SECTION B consists of FOUR questions of which you must do any TWO. To be allowed to the exam you had to submit assignment 01 on time. 2. ERRATA Prescribed Textbook: Page 503 second last paragraph sixth line should read was R = /$ =. Page 504 last sentence of the third paragraph should read For Section A16.3 appendix). page th line should read Q x and Q m = the quantity of page 558 third paragraph fifth line should read (point.b is.. Study guide: page 7: The last sentence of the first paragraph should read: Note that because of South Africa s historical dependence on gold exports it is recorded as a separate item immediately below merchandise exports. Page 48: The third paragraph (under heading 6.4D) should read: The scenario is one of external balance and internal imbalance. 4

5 ECS3703/ ANSWERS TO ASSIGNMENT 01 (First semester) You had to submit this assignment in time to be allowed to the exam. The assignment also makes a contribution to your semester mark. The answers to question 11 to 20 are provided below. Most of the answers are easily found and explained in either the guide or the textbook. We provide you with page references (SG = Study Guide and TB = Textbook) as well as short explanations where deemed necessary. NB The page references in brackets refer to the 10 th edition of the textbook. Answers: 11. (a) SG p 2. The Balance of Payments is more like a company income statement than a balance sheet. (b) SG p 2. (c) SG table 1.1 p 3. The correct alternative is (1). 12. (a) It is the trade account that comprises trade in physical goods. SG p 7. (b) This is explained in the last paragraph SG p 7. (c) The financial account records exchanges of international asset claims and not merchandise exports and imports. SG p 8. The correct alternative is (3). 13. (a) At an exchange rate of $1 = 2 more euro than before are needed to buy a dollar and thus the euro depreciated relative to the dollar (and thus the dollar appreciated). In other words, we now only need $0,50 to buy a euro. (b) This is the definition of an effective exchange rate. SG p 18. (c) To hedge against the risk of changes in the exchange rate the importer should buy the currency in which payment have to be made. In this instance he should indeed buy euro. The correct alternative is (5). 5

6 14. (a) A speculator accepts and even seeks out a foreign exchange risk. SG p 23 and TB p 422 (482). (b) Hedging as well as speculation can take place in the spot, forward, futures or options markets. TB p 422 (482). (c) The foreign currency is sold in the expectation that it will fall even lower in future. (This is most probably a contributing factor in the massive depreciation of the rand at the end of 2013 continuing into 2014 ). TB p 423 (484). Also see TB p 493 (562) fig The correct alternative is (2). 15. (a) Note that the investor runs the risk of losing money. TB p 425 (507). (b) The Relative Purchasing Power Parity Theory postulates that the change in the exchange rate over a period of time should be proportional to the change in the relative price levels. TB p 445 (507). (c) It is implicit in the monetary approach and is stated as such TB p 451 (514). The correct alternative is (4) 16. (a) This is the conclusion TB p454 (517). (b) This is the conclusion TB p462 (526). (c) An increase in wealth will result in an increase in the demand for the foreign bond according to the approach. Do not be frightened by the Portfolio Balance Theory. It is a classical example of common sense made difficult. NB: You will not be examined on the Extended version (TB section 15.4B). The correct alternative is (3). 17. (a) This is what exchange rate dynamics is about. TB p 466 (530). (b) If the real sector responded immediately, as financial sectors do, there would be no exchange rate overshooting. TB section 15.5A p 466 (530). (c) This is explained well in TB section 15.5A p 466 (530). The correct alternative is (2). 6

7 ECS3703/ (a) This is the conclusion of section 16.2A TB p 486 (555). (b) At point E the quantity of euro s demanded is equal to the quantity of euro s supplied. TB p 486 (555). (c) This can be seen in fig 16.1 TB p 487 (555). The correct alternative is (3) NB You will not be examined on sections 16.2B and 16.2C of the textbook. 19. (a) TB section 16.2C p 489 (557). (As mentioned above you will not be examined on this section). (b) The terms of trade can rise, fall or remain unchanged. TB p 491 (559) last paragraph. (c) A depreciation of, for example, the dollar increases the dollar price of US import substitutes and exports and is thus inflationary. TB section 16.3 p 490 (559). The correct alternative is (5) 20. (a) This is the general implication of the Marshall-Lerner condition. TB p 494 (563). (b) This is what is called the J-curve Effect. TB p 497 (566). (c) The mint parity is not the same as the gold export point. TB section 16.6A p 503 (573). The correct alternative is (1). 7

8 4. ANSWERS TO ASSIGNMENT 02 (First semester) This assignment also makes a contribution to your semester mark. The answers to questions 1 to 10 are provided below. Most of the answers are easily found and explained in either the guide or the textbook. We provide you with page references (SG = Study Guide and TB = Textbook) as well as short explanations where deemed necessary. NB The page references in brackets refer to the 10 th edition of the textbook. 1. (a) This is the essence of the absorption approach. SG p 42. (b) The absorption approach implicitly assumes an adequate demand for the nation s exports and import substitutes. TB p 535 (609). (c) This statement is related to the statement in (a) above. SG p 42. The correct alternative is (2). 2. This issue is explained in the first paragraph of SG p 43. Induced refers to the result of the increase in income due to the devaluation. Such increase in income may result in an increase in imports (which is called an induced rise in imports ). The answers are thus: (a) (b) (c) The correct alternative is (4). 3. Point N corresponds with exchange rate R 2 which is the exchange rate that corresponds with internal as well as external balance. All that needs to be adjusted is the domestic expenditure (absorption), in other words we have to apply expenditure changing policies alone (to move to point F). (a) (b) (c) The correct alternative is (1). 8

9 ECS3703/ Points above both internal balance line YY and external balance line EE indicate inflation associated with an external surplus (Zone II). To correct these imbalances, in other words to move towards point F, we have to revaluate the currency and apply either expansionary or contractionary fiscal and monetary policies. TB fig 18.1 p 551 (629). The answers are thus: (a) (b) (c) The correct alternative is (5). 5. (a) This is one of the conclusions of the explanation in TB section 18.4D p 559 (640). (b) This is another one of the conclusions of the explanation in TB section 18.4D. (c) Because of the assumption of fixed exchange rates the reference to flexible exchange rates is not applicable. The correct alternative is (2). 6. (a) This is one of the conclusions of the explanation in TB section 18.5B p 564 (644). Fiscal policy is ineffective. (b) This is one of the conclusions of the explanation in TB section 18.5B p 564 (644). Monetary policy is effective. (c) Point E is a point of equilibrium below full employment and the application of policy measures to attain full employment is necessary. The correct alternative is (2). 7. (a) TB section 18.7 p 572 (652). (b) TB section 18.7 p 572 (652). (c) TB section 18.7 p 572 (652). The correct alternative is (5). 9

10 8. The application of expansionary fiscal policy from initial equilibrium point E, which is at the natural level of output, merely results in an increased price level without any expansion in output, which is obviously undesirable. This is explained in TB section 19.5 p 600 (683). (a) (b) (c) The correct alternative is (3). 9. This is clearly explained in TB section 19.6A p 604 (687). Points E and G are points of natural employment and thus per definition long-run equilibrium points. (a) (b) (c) The correct alternative is (5). 10. The net result of a supply shock is a lower level of natural output which cannot be prevented by policy instruments neither by market forces and the nation thus never returns to the output level that prevailed before the supply shock. This is well explained in TB section 19.6B p 604 (687) with reference to fig (a) (b) (c) The correct alternative is (1). NB: The examination questions are all essay questions. Should you thus have battled with some of the above assignment questions, do not despair. Some of them could even have been a bit ambiguous. In the examination we are more interested in the bigger picture. Assignment 03 in Tutorial Letter 101 is thus an example of examination questions. Also see further examples of possible examination questions in sections 5 and 6 of (this) tutorial letter

11 ECS3703/ COPY OF THE Nov 2014 EXAMINATION PAPER SECTION A / AFDELING A You must answer ALL the questions in this section. U moet AL die vrae in hierdie afdeling beantwoord. 1. (a) Explain direct controls that can be used to affect a nation s balance of payments. (20) (b) Briefly explain how an importer can hedge the risk of changes in exchange rates. (5) (a) Verduidelik direkte beheermaatreëls wat deur ʼn land gebruik kan word om sy betalingsbalans te beinvloed. (20) (b) Verduidelik kortliks hoe ʼn invoerder homself kan verskans teen die veranderinge in wisselkoerse. (5) 2. Explain the simple version of the portfolio balance approach to the balance of payments. Verduidelik die eenvoudige weergawe van die portefeuljebalansbenadering tot die betalingsbalans. SECTION B / AFDELING B You must answer TWO of the following FOUR questions. U moet TWEE van die volgende VIER vrae beantwoord. 3. Discuss the South African balance of payments. (Name all the items and then discuss). Bespreek die Suid-Afrikaanse betalingsbalans. (Noem al die items en bespreek daarna) 4. (a) Illustrate with the aid of a diagram (use aggregate demand and aggregate supply curves) how a government can use fiscal and monetary policies to stimulate growth in an open economy. (18) (b) Explain translation risk that may arise in international transactions. (7) (a) Toon aan met behulp van n figuur (gebruik totale-vraag en totale-aanbod krommes) hoe ʼn owerheid fiskale en monetêre beleid kan gebruik om groei te stimuleer in ʼn oop ekonomie. (18) (b) Verduidelik die omrekeningsrisiko wat gepaard kan gaan met internasionale transaksies. (7) 5. (a) Explain the proposals that have been advanced for reforming present exchange rate arrangements. (17) (b) Explain Currency Board Arrangements briefly. (8) 11

12 (a) Verduidelik die voorgestelde maatreëls ter hervorming van die huidige wisselkoersbedeling. (17) (b) Verduidelik Valutaraadooreenkomste kortliks. (8) 6. (a) Explain the difference between foreign exchange futures and foreign exchange options. (10) (b) Explain the difference between a stable and an unstable foreign exchange market with the aid of two graphs. (15) (a) (b) Verduidelik die verskil tussen vooruitkontrakte ( futures ) en opsies op die buitelandse valutamark. (10) Verduidelik die verskil tussen ʼn stabiele en ʼn onstabiele valutamark met behulp van twee figure. (15) 12

13 ECS3703/ General information Additional remarks regarding the exam and the preparation for it: Use keywords to summarize when studying lengthy topics. Write as much as you can in the exam on a topic within the time limit. Write legible. The exam is not only about graphs. There are also questions on the easier sections. No calculations will be required. Additional sections of the textbook are not prescribed for the exam (see below). Examples of examination questions To help you with your preparation for the examination we have decided to provide you with 10 possible examination questions. We cannot guarantee that any of these questions will be in the exam paper but it is possible that some of them can be. The questions in assignment 03 (first and second semester) are also from previous exam papers. Together with the copy of the Nov 2014 paper above you now have more than enough of such questions. 1. (a) Explain the difference between foreign exchange futures and foreign exchange options. (10) (b) Evaluate the significance of imbalances that may occur within the balance of payments. (15) 2. (a) Explain (with the aid of a diagram using the IS/LM/BP analysis) the effectiveness of expansionary monetary policies in an open economy with flexible exchange rates and perfect capital mobility. (16) (b) Discuss the current account of the South African balance of payments. (9) 3. Explain (with the aid of two diagrams using the IS/LM/BP analysis) the effectiveness of expansionary fiscal policies as well as easy monetary policies in an open economy with flexible exchange rates and perfect capital mobility. 4. (a) Explain currency pass-through. (10) (b) Discuss foreign exchange risks. (15) 5. (a) Define the following briefly: Devaluation (2) Revaluation (2) 13

14 Currency swaps..(3) (7) (b) Suppose a nation with an open economy and fixed exchange rates is in short-run equilibrium below its natural level of output (in other words, in a recession). Explain with the aid of a diagram (use aggregate demand and supply curves) the effect of expansionary fiscal policy. (18) 6. (a) Name all the items of the current account of the South African balance of payments. (10) (b) Explain currency board arrangements. (15) 7. Discuss the Purchasing Power Parity theory. (25) 8. Discuss the operation as well as the evolution of the Bretton Woods System. (25) 9. (a) Explain, with the aid of a diagram (using aggregate demand and supply curves), how a government can use fiscal and monetary policies to stimulate long-run growth in an open economy. (18) (b) Explain transaction risk that may arise in international transactions. (7) 10. (a) Explain the J-curve effect. Include a graph in your answer (8) (b) Describe the case for fixed exchange rates (no graphs required). (17) 14

15 ECS3703/201 NB! The above 10 questions are not the only possible exam questions. You must therefore still know the remainder of the prescribed material to earn a good mark. Material not prescribed for the exam: In addition to that already mentioned in the study guide you can also omit the following sections from the textbook as far as the examination go: Chapter 13 (only the information in study unit 1 of the Study Guide is applicable for the exam in this regard). Section 14.6C Section 16.2B Section 16.2C Sections 18.3 up to (and including) 18.4C (pp )( pp th ed) Section 18.5A Section 19.2A up to (and including) 19.4B (pp ) (pp th ed) Another example of covered interest arbitrage: Assumptions: Interest rate in the RSA = 10% per year Interest rate in the USA = 3% per year Spot exchange rate is $1,00 = R10,00 One year forward rate is $1,00 = R10,50 A USA citizen with $100,00 wants to investigate the possibility of arbitrage profits by investing it in the RSA To invest in the RSA she will have convert her $100,00 to R1000,00 on the spot market and invest it in the interest rate (resulting in R1100,00 after a year) and simultaneously cover it (hedge) using the forward rate. That means the bank guarantees her that by the end of the year she can convert her money back to $ at the rate of $1,00 = R10,50 resulting in $104,76 (R1100,00 R10,50) Comparison: Should she have invested her $100,00 in the USA it would have grown to only $103,00 by the end of the year. She thus makes an arbitrage profit of $1,76 ($104,76 - $103,00) by rather investing it in the RSA. At a forward rate of $1,00 = R10,68 no arbitrage profits will be possible (R1100,00 R10,68 = $103,00) What has been said above considerably reduces the workload for the exam. Start studying early and make the best of this opportunity 15

16 7. COMMUNICATION WITH LECTURERS The following lecturers are involved with this course. Appointments with the lecturers should be made in advance. Mr N. Mkhize Tel (012) Ms K. Amusa Tel (012) NB: The telephone lines at Unisa are very busy during exam time. You must therefore go through your work in time and make contact with us in time, should you encounter problems. There is no guarantee that you will be able to find a lecturer in the last days before the exam. Best wishes with your studies. N. Mkhize K. Amusa 16